Inflation targeting has worked for India, but transparency must improve

The Reserve Bank of India (RBI) has initiated the second statutory review of the flexible inflation targeting (FIT) framework it has used since 2016. Its recent discussion paper seeks public feedback on whether FIT, which has anchored the Monetary Policy Committee’s (MPC’s) decisions for nearly a decade, remains relevant for India’s economy. 

The paper raises four questions: Should the RBI target headline or core inflation, given food’s dominant weight in retail price index? Is the 4 per cent inflation target with a tolerance band (+/- 2 per cent) still appropriate for a fast-growing economy? Should the tolerance band be adjusted or scrapped entirely? And should the point target give way to a more flexible range-based approach? 

To answer, it is useful to understand what the framework has delivered. Since May 2016, headline inflation has averaged just around 4.8 per cent. Expectations, once volatile, have become more stable. The median one-year-ahead inflation expectation has declined significantly from earlier double-digit peaks towards a narrower range of 8 to 10 per cent. Even when price pressures surged above 6 per cent— in 2019, when onion prices spiked, during the Covid-19 pandemic, and after Russia’s invasion of Ukraine — the RBI’s Inflation Expectations Survey of Households (IESH) shows that expectations remained strongly anchored. That is no small achievement. FIT has ended India’s long cycle of inflation surges and stop-go monetary policy. 

The anchor has held because it aligns with how inflation is experienced in India. Food and fuel account for nearly 50 per cent of the consumption basket for the poor, and price surges in these items dominate the lived experience of inflation. In a financially constrained economy, where credit markets are shallow, poor households cannot easily smooth consumption. Thus, food shocks quickly feed into demand and wages. That makes headline inflation, not core, the welfare-relevant measure. Targeting a narrower index, stripped of food and energy, would effectively de-anchor inflation expectations and weaken the legitimacy of the RBI’s monetary policy. 

What of the target itself? After July’s undershoot to an eight-year low of 1.55 per cent, the allure of lowering the target is easy to see. Conversely, many analysts argue that raising it could help accommodate transient supply-side shocks. Both temptations should be resisted. The RBI’s own analysis shows that 4 per cent inflation roughly coincides with a zero-output gap, balancing price stability with growth. Importantly, after nine years, the 4 per cent target has become a Schelling point around which expectations, politics and markets seem to have converged. There is little case for shifting it. 

Nor is there a case for abandoning the point target with tolerance bands in favour of a bare range. Behavioural evidence shows expectations anchor around clear midpoints, not fuzzy intervals. The midpoint disciplines both policymakers and price-setters. Narrowing the 2–6 per cent corridor would force the MPC into pro-cyclical tightening whenever the monsoon falters or oil prices jump; a wider band would blur accountability when rising global uncertainty may demand monetary discipline.

 

India’s inflation record over recent years has been shaped less by demand imbalances than by recurrent supply shocks, such as volatile food prices, erratic monsoons, energy price swings, and geopolitical developments. Many have questioned whether FIT can remain effective in such an environment. Recent evidence suggests that the framework has improved policy traction despite higher volatility. Work by Raghuvanshi and Ahmad (2024), published in the Journal of Asian Economics, shows that since adopting FIT, the interest-rate and credit channels have become more effective in restraining inflation, while their impact on output has diminished. Monetary policy now transmits more directly to prices with less collateral damage to growth, clearly a hallmark of a firm, credible anchor. FIT has allowed the RBI to respond calmly to shocks, without the overcorrection cycles that once unsettled growth.

 

What must evolve is the framework of accountability and communication that supports FIT. The RBI’s statutory obligation under Section 45ZN — writing to the government when inflation remains outside the band for three quarters — must become a more transparent accountability exercise, much like how the Bank of England follows an “open letter” system. The public report should explain the reasons for the breach and the horizon over which inflation will be steered back to 4 per cent. The RBI must also publish policy-consistent inflation projections and the expected timeframe for a return to target, making its intent easier to assess and its response function more predictable.

 

The RBI should also strengthen signal extraction while keeping headline consumer price index (CPI) as the legal target. It could publish core measures like trimmed-mean or median indices to separate temporary spikes from persistent pressures. The Bank of Canada does so with CPI-trim and CPI-median, giving a clearer view of underlying trends without weakening the anchor.

 

With fiscal pressures rising worldwide and monetary independence under strain, the anchor must remain. We must not fix what is not broken. The imperative is to make flexibility predictable and accountability visible. That is how the RBI can continue to preserve its hard-won credibility.

  The author is assistant professor (economics) at IIM, Ranchi. The views are personal